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An Anatomy of Currency Strategies: The Role of Emerging Markets

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  • Mikhail Chernov
  • Magnus Dahlquist
  • Lars A. Lochstoer

Abstract

We show that a small set of emerging markets with floating exchange rates expand the investment frontier substantially relative to G10 currencies. The frontier is characterized by an out-of-sample mean-variance efficient portfolio that prices G10- and emerging markets-based trading strategies unconditionally as well as conditionally. Our approach reveals that returns to prominent trading strategies are largely driven by factors that do not command a risk premium. After real-time hedging of such unpriced risks, the Sharpe ratios of these strategies increase substantially, providing new benchmarks for currency pricing models. For instance, the Sharpe ratio of the carry strategy increases from 0.71 to 1.29. The unpriced risks are related to geographically-based currency factors, while the priced risk that drives currency risk premiums is related to aggregate consumption exposure.

Suggested Citation

  • Mikhail Chernov & Magnus Dahlquist & Lars A. Lochstoer, 2024. "An Anatomy of Currency Strategies: The Role of Emerging Markets," NBER Working Papers 32900, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:32900
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    More about this item

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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